Monday, October 19, 2015

The Subprime Unicorn Boom in Tech?

The private and public worlds of technology collided this week with a set of stories about two very different companies: one a large business in its fourth decade, seeking to adjust to a new world; the other a much touted Silicon Valley start-up whose ambitious scientific claims were questioned in a devastating newspaper article. The former, Dell, and the latter, Theranos, illustrate the benefits and perils of life as a private company.

Michael Dell had experienced many years as the head of a publicly traded company, which included some close encounters of the worst kind and a bruising battle with some dissident shareholders, before delisting in a leveraged buyout in 2013.

Since then, relieved from the merciless roasting of the quarterly earnings call, he has had the freedom to undertake a long-term restructuring of his business. Mr Dell emerged from the shadows this week to announce his intention to purchase EMC, the large storage provider, in what would be the biggest technology takeover in history.

If Mr Dell illustrated the benefits of privacy, Elizabeth Holmes, the chief executive and founder of Theranos, has just learnt that even for the head of a high-profile, secretive Silicon Valley company valued at $9bn, a light will eventually illuminate dark places.

Ms Holmes formed Theranos in 2003 to provide health tests from a few drops of blood rather than what gushes out of several tubes. Ms Holmes ingeniously convinced some very accomplished people (including Oracle’s Larry Ellison) to furnish her company with about $400m and has persuaded two former US secretaries of state, a former US defence secretary and the former chairman of the Senate Armed Services Committee to join her board of directors.

That feat of persuasion may have been even more impressive than it seemed. The Wall Street Journal this week reported claims that the company’s proprietary technology — whose co-inventor committed suicide two years ago after telling his wife that it was not effective — is used only in a small fraction of the company’s tests, with others performed using standard laboratory equipment in a way that might produce inaccurate results. Former employees of Theranos told the newspaper they had been instructed to deal with regulatory checks on its test results in a way that might amount to cheating.

Theranos contests these suggestions of scientific trickery and legerdemain. However, if they turn out to be true, the company could be mortally wounded — a development that might make technology investors sit up straight and be less credulous as they scrutinise investments.

Life in the shadows of the private market has many benefits for emerging companies. It allows them to experiment, work out kinks in a product, lure talented people with attractively priced stock options, shield themselves from the scrutiny of predatory competitors and stutter in private until they can speak fluently in public. It is also a refuge to which people such as Mr Dell can retreat once their companies no longer offer public investors either the growth or predictability for which they yearn.

But there is also a false sense of security provided by the private markets at a time when interest rates are negligible and many investors, particularly those who are either new to technology or have short memories, are all too willing to back start-ups whose premises house several baristas and where a dozen blends of tea (not to mention the sea-salt flavoured chocolate bars and bio-dynamically raised Anjou pears) are de rigueur. It is easier to conceal weaknesses, present an aura of invincibility and confound investors as a private company that can escape by making fewer disclosures than as a publicly traded one.

One glance at the list of so-called unicorns — those private technology companies valued at more than $1bn — illustrates this point. A handful of these businesses will become the great, enduring companies of tomorrow. But a good number seem the flimsiest of edifices. Forget the fact that some of these valuations are illusory because the most recent investors have structured their investments as debt in all but name, meaning that they will stand to profit even if the company is worth far less.

The more salient point is that for the past three or four years private investors have just been more forgiving than their public market counterparts, who, had they been presented with the most recent financial reports of a good number of these companies, would have decimated the stocks. In the past few quarters, the founders of several technology companies have discovered a far chillier reception as they tramped around on initial public offering roadshows than they were accorded in the private shadows.

Most of the leaders of the subprime unicorns who continue to enjoy the fruits of the private market delude themselves about the difference between control and discipline. Some say that if their companies become public they will lose control. Google, Facebook and a raft of other companies with dual-class stocks put paid to that argument. What the heads of the subprime unicorns really mean is that the sort of disclosure required of a public company is the picture they do not want to view. But as Ms Holmes of Theranos discovered this week, eventually there is no place to hide.

But when one of Silicon Valley's heavyweights writes a scathing article criticizing 'unicorn' valuations of startups and singles out Theranos, I pay attention. Why? I'll let you read Michael Moritz's background here but suffice to say he played an instrumental role in making Sequoia Capital the powerhouse VC fund that it's become.

I actually spoke to Doug Leone, Moritz's partner at Sequoia, back in 2004 when I was working at PSP Investments. I got his name from one of my books on venture capital, called and left him a message. To my surprise, he called me back. I told him that Gordon Fyfe and Derek Murphy, the former president and head of private equity at PSP, were going to visit California and wondered if he would meet with them to discuss venture capital.

Leone cut to the chase immediately. "Listen, we don't deal with public pension funds. We don't need money. Our last fund of $500 million was over-subscribed by $4.5 billion. Our partners are fighting on whether to allocate more to the Harvard or Yale endowment funds. My best advice to PSP is to stay away from venture capital, you will lose your shirt."

That was a short call but I persisted, called him back and told him we are not interested in investing in venture capital but we would love to chat with him. Finally, he obliged and said: "Ok kid, I like your persistence, tell them I'll give them 30 minutes."

When Gordon and Derek came back from California, they came to my office and told me that was by far the best meeting of their trip. Gordon said he learned a lot from talking to Doug Leone and was in awe of Sequoia and how it brought stellar companies like Apple and Google public, making billions in the process. Murph blurted out something like "f*ck did I feel poor talking to this guy." (my buddy, Mike Petsalis, CEO of Vircom, a Montreal based tech company that provides email solutions to organizations, loves that story and tells me it's by far his favorite PSP story).

In other words, people like Michael Moritz, Doug Leone and others that work at Sequoia Capital operate at another level and when they discuss the 'subprime unicorn' boom in tech and single out a company, you'd better pay close attention. These people are the cream of the crop and while they might have their angle and agenda, they don't put out warnings for the sake of it. They don't need to.

In November 2008, almost seven years ago, Sequoia Capital put out a presentation, R.I.P. Good Times. When I covered it, I felt things were getting way too bearish and overdone but I do remember how that presentation ended with an ominous warning, Get real or go home.

It it possible that many of the startups in Silicon Valley are way overvalued and not scrutinized enough? You better believe it. One of my buddy's out there who has worked at premiere companies tells me that quantitative easing was a boon for startups but things are drying up fast now.

"I read this and was like duh. People are throwing at Altman and he needs to find a way to invest, more startups through YC is going to lower the quality so better to invest in bigger names.

The moralizing about nuclear power is interesting. A lot of VCs are trying to pretend they are more than just hustlers between rich people and entrepreneurs... As if they are visionary technologists - the real visionaries of the future. This kinda looks like a lame claim when you are invested in Snapchat and your top entrepreneurs don't have that visionary tech stench.

I call it - deep tech wash - investing in one deep tech so you can pretend you are really investing in something that is meaningful. Cynical me."

I'm just as cynical on a lot of startups but I must admit, this whole Theranos affair fascinates me. Another friend of mine here in Montreal, sent me this following my weekend comment:

"Theranos always seemed a little too good to be true. I hope they can do what they say they will.

But I know that there is a lot of money out there. And sometimes hope triumphs over reality. So maybe this was a lot of hype - justly created by people who invested a LOT of money.

Maybe we'll see a successful product. But I wasn't completely surprised by the articles. And I'm inherently suspicious of the billionaire who's made her money by starting a company that hasn't produced anything yet."

I told him that Theranos has a product which is already in use and has signed deals with Walgreens. Moreover, one of the backers of this startup is Oracle's Larry Ellison, one of the richest and shrewdest businessmen in the world. Guys like Ellison don't throw their money away in crackpot startups.

Theranos Inc. is a Silicon Valley start-up that over the past year had been acquiring immense attention, and a valuation of billions of dollars, for a blood-testing technology that was poised to revolutionize the field — cheap, easy, informative blood tests obtainable on demand at your corner pharmacy.

That changed last week, when articles in the Wall Street Journal reported that the firm has struggled to show that its technology works, and suggested that it may have been misleading the public, and possibly government regulators, about the effectiveness and accuracy of its technology. Now it's showing what happens when Silicon Valley hype outpaces reality.

Theranos called the Journal's findings "factually and scientifically erroneous and grounded in baseless assertions by inexperienced and disgruntled former employees and industry incumbents."

Silicon Valley is often lauded as an ecosystem that fosters high-tech growth through the interaction of venture capital, technological know-how, and yes, PR. Theranos points to the downside of the same phenomenon, in which interest by venture investors feeds on itself, and the publicity machine may gloss over how much work needs to be done to actually bring a "revolutionary" breakthrough to fruition.

A common adage is that venture capital is expensive money, but smart money; by contrast, stock market capital is cheap money but dumb money. The idea is that stock investors throw money at you but expect unrealistic results; venture investors demand big chunks of your company, but their wisdom and experience help you grow.

Theranos may demonstrate the flaws in this generalization. If the rap on the firm's technology is even partly true, then its $9-billion venture valuation reflects investor's hopes and fantasies rather than the technical knowledge and rigorous financial assessment for which the venture community prides itself.

More than the reputation of Theranos and that of its entrepreneurial founder, 31-year-old Elizabeth Holmes, is at stake. Venture investors have poured a reported $400 million into Theranos on terms that value the firm at $9 billion; Holmes' stake is said to be worth more than half that.

Yet much of the excitement about Theranos has always been based on irrelevant or misleading markers of success — or on Holmes as a personality. A profile in Inc. magazine this summer called her "America's coolest billionaire" and featured such nuggets as a letter she supposedly wrote to her father at age 9 attesting, "What I really want out of life is to discover ... something that mankind didn't know was possible to do." She dropped out of Stanford in her sophomore year, Business Insider reported, because she decided that "her tuition money could be better put to use by transforming healthcare." Her evocation of the image of Steve Jobs, down to her wardrobe of black turtlenecks, rarely went unremarked.

The most recent profile of her appeared just last week in a glossy feature supplement to the New York Times naming her among "Five Visionary Tech Entrepreneurs Who Are Changing the World." The article focused not on the technological robustness of Theranos' product, which outsiders haven't been able to assess, but on the premasticated life history of Holmes, who "has always been a bit of an outlier. As a child, she studied with a tutor to become fluent in Chinese..." And so on.

(The article's author, Laura Arrillaga-Andreessen, is the wife of Silicon Valley venture investor Marc Andreessen, though Theranos isn't listed as a portfolio company of Andreessen Horowitz, his venture firm.)

What about that transformation of healthcare? In a widely viewed video of a talk she delivered last year at TEDMED, Holmes describes on-demand blood tests as an issue of personal empowerment. "When people have access to information about their own bodies," she said, "they can change outcomes."

That sounds unexceptionable, even laudable, but healthcare is more complicated. As John P.A. Ioannidis of Stanford Medical School observed for an article in the Journal of the American Medical Assn., Holmes' talk ignored the drawbacks to expanded consumer-driven blood testing, such as "overdiagnosis, false-positive findings, or the potential for ... misplaced and perhaps overly zealous diagnostic and screening efforts."

As it happens, questions had been raised about Theranos' claims for months — but they had been swamped by a tide of fawning publicity. Ioannidis noticed that information about Theranos had appeared in the Wall Street Journal, Business Insider, Fortune and Forbes, "but not in the peer-reviewed biomedical literature. A few articles mentioned Theranos' policy of keeping data and technical details out of public view. The New Yorker acknowledged that the secrecy "troubled" some observers, but then quoted an expert calling that "the Steve Jobs way."ture."

In many articles, the company's choice to develop its technology secretly, as "stealth research," was treated as a virtue. But to Ioannidis, it presented a risk: "Stealth research creates total ambiguity about what evidence can be trusted in a mix of possibly brilliant ideas, aggressive corporate announcements, and mass media hype."

A few articles mentioned Theranos' policy of keeping data and technical details out of public view. The New Yorker acknowledged that the secrecy "troubled" some observers, but then quoted an expert calling that "the Steve Jobs way."

Writing in a peer-reviewed journal of clinical chemistry, Eleftherios P. Diamandis, a clinical pathology expert at the University of Toronto, asserted that the company's pitch was based not merely on exaggerated claims for its own technology, but unwarranted criticism of competing technologies —traditional blood tests offered by companies such as Quest Diagnostics and Laboratory Corp. of America. Most of their tests cost as little and could be done as quickly as those Theranos was offering, he said

One other aspect of Theranos' publicity is the question of sexism — or, to be precise, reverse sexism. The youthful Holmes is a glamorous figure, tailor-made for the mass culture promotional machine. Part of her appeal is the supposed incongruity of someone of her youth, gender and charm achieving so much so quickly.

Now 93, Shultz joined the Theranos board and recruited many of his high-profile friends, including former Defense Secretary William Perry, former Sen. Bill Frist, and Henry Kissinger. Few of the board members had any real experience in the biomedical field. (Frist, a heart surgeon, hadn't practiced in decades.) But their eminence was seen as validation of the company's pitch.

It's unquestionably possible that the questions about Theranos really do reflect inflated expectations about a truly transformative technology still in its developmental phase, as the company's outside lawyer, David Boies, told the Wall Street Journal, and that in full bloom it really will change everyday diagnostics. But such transformations appear more rarely than one would conclude from the ease with which the term "revolutionary" is tossed around in Silicon Valley.

The lesson of Theranos may turn out to be that when investors and PR firms are all selling the same story, the proper response may be to "think different," as Steve Jobs' Apple ads used to say.

Another close friend of mine, a doctor who works with Dr. Ioannidis at Stanford Medical School and has the highest respect for him and his work shining the light on dubious medical literature, shared this with me via email:

"As you know, hype is everywhere . It can sometimes be useful to get people excited about a concept but many times it's harmful (e.g Dr. Oz). Most CEOs are full of hype and it seems as if the more hype they dish out, the more they get paid around here."

So is Theranos just hype and yet another example of the 'subprime unicorn' boom in tech? I don't know but I sure hope not because I really like Elizabeth Holmes and hope to see her vision come to fruition one day soon so we can all walk into a pharmacy or clinic, prick our finger and get quick and reliable results on our health status.

But I've been living with multiple sclerosis (MS) for close to twenty years and my buddy is right, I've seen a lot of hype in MS treatments, many of which turned out to be pie-in-the-sky like Dr. Zamboni's controversial 'liberation treatment' (I did it in Albany and have no regrets but was disappointed when I saw it turned out to be ineffective).

There's a lot of hype in medicine and biotech which is why my buddy at Stanford always warns me to wait till I see the results of one or two or three randomized double-blind placebo controlled phase III studies which are peer reviewed before I get excited about any new treatment.

Moreover, many unicorns in Silicon Valley will be extinct just like many more hedge funds are going to close their doors even after they cut their fees in response to a brutal shakeout. In my opinion, there is no end to the deflation supercycle and it will wreak havoc on venture capital and other alternative investments. Whether or not this means Theranos will be "mortally wounded" remains to be seen.

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